Investors who rely on active management are implicitly expecting that value will be added by each intermediary in the chain of agents who are involved.
Consider a client giving money to her investment advisor, who invests it on her behalf in a mutual fund that in turn hires asset managers as subadvisors who actually put the money to work. There are four levels of selection involved: the client selecting the advisor, the advisor selecting the fund, the fund company selecting the subadvisors, and the subadvisors selecting the securities.
What are the probabilities at each step that the selection process is one that adds value?
Elusive advantages
Let’s narrow it down to a simpler case, that of an asset manager being chosen by an institutional capital allocator. The question remains: What are the chances that the manager has an edge over a relevant benchmark and other managers — and that the allocator has one in its selection process too?
As is well advertised, asset managers as a group fail to add value after fees in most asset categories and vehicle structures. The selection effectiveness of institutional investors and consultants is harder to evaluate, but studies generally indicate that they also struggle to identify outperformers.
Yet despite the amount of money that has flowed into passive strategies, active management is still at the core of most institutional investment programs. Certainly there are asset managers who outperform over short periods and a few that manage to string together attractive long-term performance. The same goes for allocators. But the odds are against both pursuits.
Sharpening the sword
The heart of the problem: If managers and allocators play the game as it is normally played, they should expect to get the results that most others do.
In rebuttal, an organization might say that their people are smarter or better — so that they are like a sports team with superior talent, playing the same game but winning with regularity. But is that really true, and will it be sustainable as times change, markets change, and people change?
Only by relentlessly moving on from what has produced attractive returns to what will produce attractive returns can an investment organization stay ahead of the evolution in the ecosystem that grinds down edges over time. That requires a culture with an innovative mindset, including the willingness to do things differently than the crowd today and to change over time in the face of social pressures to stick with what has worked before.
Look both ways
One theme of the Investment Ecosystem due diligence course is the need to “look both ways.” That is, allocators learning the finer points of qualitative analysis to judge asset managers should use those same principles to evaluate their own organization. (Just a few of the topics where that is the case: beliefs, behavior, culture, narratives, decision making, and investment process.) The shortcomings and opportunities for assessing an allocator’s organization often mirror those for an asset management firm. After all, they are both collections of humans trying to figure out and profit from the vast social system of markets. Despite their different roles in the ecosystem, there is a great deal in common between them, including generally accepted practices (and generally accepted weaknesses).
One example (directly to the point of not playing the game differently than others) is the amount of time and effort spent on documenting and ingesting the stories of the entities that they research. There’s a similarity between how analysts and portfolio managers assess companies and how allocators assess asset managers.
If you could do time studies of each party, you would find that significant chunks of time are devoted to listening to, recording, and regurgitating in various ways the narratives of those that they are responsible for evaluating (and the data provided by them or that is otherwise publicly available). The main stream of information for active equity managers is the companies that they cover; for allocators it’s the managers that they cover. A large part of each of those jobs is documenting that information and passing it along, for it to be parsed and interpreted and relied upon for decision making.
Thus, it is common to hear someone say, “We have done our due diligence,” only to discover that what has been done is the recording of the offered narrative and the available data, with little or nothing in the way of true discovery beyond it. As a result, decisions are made on the basis of the same information that is given to everyone else. It’s no wonder that outperformance is elusive.
Reorienting the quest
The goal of active management — at whatever level in the chain of agents — should be the uncovering of differential information, not the sifting through of that which is widely available in the expectation that through greater powers of discernment value will be added on a consistent basis.
Given the technology already in hand and the prospect of even greater capabilities on the way, there should be an intentional shrinking of the time spent by analysts on capturing (and endlessly re-capturing) the narrative.
The real work in well-crafted investment processes ought to be that of differential intelligence, especially of the disconfirming variety, since that is valuable given how investment stories get entrenched. Those differentials then ought to be front and center during the decision making process. The next time you read a research report or recommendation — or sit in on the presentation of an idea before an investment committee — judge for yourself whether there are unique elements that can’t be found in other accounts. Usually it’s just the passing along of the narrative with an attached opinion about whether to invest or not.
To alter the orientation of the research effort, there are needed changes in the structure of roles, the nature of due diligence, the content of reports, and how decisions are made. But such changes are resisted, because “that’s not the way things are done.” Everyone plays the same game and unconventional thinking is discouraged, even though unconventional thinking is what animates good active management.
Two edges
The expectation is that manager selection will take advantage of two edges, that of the manager and that of the selector. But, like the blades of a sword, each of those edges gets dull and chipped. They need to be honed to keep them sharp — although over time they can get so thin that they become ineffective. The sword as museum piece rather than as an advantage in battle.
Of course, the common usage of the phrase “double-edged sword” has a different meaning, referring to something that has both benefits and disadvantages. Active management offers the possibility of outperforming the crowd, but it generally falls short, because the fee load can’t offset whatever alpha is produced.
Therefore, to have a chance to win at the game, believers in active management have to be willing to play it differently, to continually focus on improving methods in ways that others don’t. But that is not the focus of most asset manager and allocator organizations.
Here is a selection of due diligence postings from the archives.
Published: November 16, 2023
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